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October 25, 2013

Desert Island Portfolio: What Would You Buy if No One Was Watching?

Sheltered from 24/7 news and short-term thinking, the best investments are in the “most feared and loathed” sectors, Research Affiliates says

(Photo: AP)

What would be the best portfolio in today’s market if 24/7 news cycles and portfolio statements did not imperil your reputation through short-term dips?

That “Desert Island Portfolio,” as John West of Research Affiliates calls it, would consist of today’s “most feared and loathed” areas of the market: emerging stocks and bonds.

Emerging-market stocks and bonds are poised to significantly outperform U.S. stocks and bonds over the coming years — based on current valuation criteria — but most investors will lack the nerve to buy them, or if they do buy them, to hold them.

So argues an analysis by West, a managing director of Rob Arnott’s Research Affilliates, based on the idea that advisors and managers of capital are constrained from optimizing returns by the fact that all professionals must report to someone.

West cites a variety of evidence that continuous performance measurement pressures investment professionals to manage short-term returns to avoid the risk of falling short of benchmarks and peer groups. After all, the client, after firing you, won’t get the benefit of the long-term investment gains, anyway.

That’s “almost a full 1,000 [basis points] compounded per annum for five years” over U.S. stocks, which at a Shiller P/E of 23.8, currently reside in the 90th percentile of their historic range and can expect median nominal returns of 4.2% per annum over the next five years based on historical averages. (Using more conservative assumptions for emerging-market stock performance, West posits a still healthy 500 basis-point advantage over U.S. stocks.)

Projecting a range of probable outcomes, West points out that the Desert Island portfolio’s bottom quartile result, at 3.69%, is superior to the median, 3.32% outcome for the Mainland portfolio.

Thus the odds strongly favor “going maverick,” that is owning an out-of-the-mainstream asset mix. West calculates the Desert Island portfolio has an 80:20 or 90:10 likelihood of beating the Mainland portfolio over the next five years.

But measured over the next five quarters, those odds fall to only a 55:45 advantage. And therein lies the rub. With Desert Island’s 7% tracking error against Mainland, “short-term performance would vary widely and inevitably produce a bad year of relative underperformance, perhaps on the order of over 1,000 bps,” he writes.

“Only the most dedicated of contrarians could stick with such short term underperformance and, just as critically, convince clients to do the same,” he adds.

The sell-off in emerging market stocks and bonds this year creates opportunities for maverick investors, he concludes — those willing to buy amid bad news and those able to hold “when clients get short-term indigestion,” West concludes.